Politicians are tempted by the siren song of populism which sacrifices sensible policy for applause lines. They should be careful of the unintended consequences of their eagerness to attack evil hedge fund managers.

For about a decade some politicians have been attacking managers of private equity firms for making too much money. The term hedge fund is thrown around less as a description of a particular investment vehicle and more in disdain for people we are supposed to detest — those “hedge fund people” who don’t do anything except play with money.

In reality, hedge funds and other categories of private equity funds are simply individuals and institutions who pool their resources and use a manager — usually someone with an ownership interest — to decide how to invest their money. Popular mythology suggests these are idle rich people gambling — the equivalent of a dog track for bored Wall Street investors. The truth is quite different.

Hedge funds — pooled resources — are as mainstream as mutual funds and 401k plans. According to a KPMG study, institutional assets — pension funds, college endowments, and the like — account for 65% of assets being managed and continue to grow as a percentage. Increasingly, pension funds — including our own state retirement system — make these investments a growing part of their portfolio.

This pooling of capital, whether from individuals or institutions, is a critical part of the economy. Entrepreneurs with a good idea rarely have the capital, the financial resources, to bring their idea to market. We depend on them finding someone or a group of someones willing to risk their capital and potentially lose it all or make a significant capital gain. One random rich guy with a lot of other things on his plate can only investigate so many projects and invest in a few things. A pool of investors, most of whom are institutions, can bring together more resources and hire the best managers and researchers.

The managers are the ones directing capital, often sharing in the risk, and performing a critical economic role of putting those willing to assume significant financial risk in partnership with those who have ideas but not the capital to implement them. Those managers do very well, sharing in the significant capital gains that are the reason the investment pool or hedge fund is organized.

That often annoys the rest of us and makes targets out of the hedge fund managers.

The manager is usually paid a salary but will also share in the capital gain. It is typically the case that the active manager will receive a 20% share of the total capital gain while the passive investors — like the pension fund — share the other 80%.

Populists are able to marry popular annoyance at the manager and supposed tax reform by claiming the tax treatment is unfair. Capital gains, largely because of the risk involved in capital investment and the critical importance of capital to any economy, are taxed differently from salaries. Long term capital gains are taxed at 20%.

Populists would have us tax the capital gains of the manager — usually called carried interest — at the higher wage rate and the other 80% at the lower capital gains rate. The same money would be treated differently because we don’t like the manager who earned it.

This is of course ridiculous. Carried interest is capital gains, pure and simple. If it’s a gain for the 80% passive investors then it is for the other 20% as well.

We know that raising capital gains taxes will hurt the economy. When Bill Clinton — yes that Bill Clinton — cut capital gains taxes in 1997, he cut the rate by 30% yet capital gains tax receipts grew by 18% per year for the next three years because of increased economic activity. The same was true of the 1981 and 2003 capital gains tax cuts and the reverse was true of the 1987 capital gains tax hike.

Raising the capital gains tax is simply bad for the economy. Pretending the manager’s share of the capital gains aren’t really capital gains isn’t fooling anyone. It isn’t as if economic reality is changed simply because you relabel it. If Bill Clinton’s capital gains tax cut and the other two in the last 35 years each led to greater economic activity, what action should we take on capital gains taxes if we want economic growth? Go ahead, I bet you can figure it out.

1 – Many if not most money managers for institutions do not charge a carry.

2 – Most significant for tax purposes, hedge fund managers do not pay any substantial thing for their carry except their services. The carry is in fact a payment for services; it is not the return on a capital investment. The common man would consider payment for services ordinary income, not a capital gain.

Incidentally, the only discernible uniform difference between a “hedge fund” and other types of investment funds is the existence of the carry.